Markets & Finance

Why Hewlett-Packard Stock Looks Like Good Value


HP's acquisition of EDS, low p-e ratio, and push into services have made it an attractive IT play

From Standard & Poor's Equity ResearchHewlett-Packard (HPQ; recent price, 43) is a top-tier maker of computer hardware and printers that is growing by acquisition in services and software to become an even larger provider of information technology solutions. We believe that the advantages of larger scale and better balance between complementary hardware, software, and services segments include attracting customers seeking one-stop shopping, more recurring and stable revenue streams, better global market coverage, and, not least, a big opportunity to enhance profitability by cutting operational costs.

The company recently undertook an ambitious acquisition of Electronic Data Systems (EDS), which we believe offers HP the opportunity not only to beef up the services component of its three-segment strategy but also to create value through reorganization and cost-cutting on a large scale. In our view, the management team under Mark Hurd, CEO since Apr. 1, 2005, has demonstrated its ability to improve profitability by focusing on costs. For instance, HP's return on equity went from about 6.4% in fiscal 2005 (October), to about 19.0% in fiscal 2007. Although restructuring charges may blur the GAAP-based earnings and margin picture for about two years, we expect EPS improvement on an ex-charges basis and believe the company will emerge as a stronger organization after EDS is fully integrated.

We view HP shares as very attractively valued, at a recent price-earnings ratio of 11.6 times, based on our calendar 2008 EPS estimate of $3.72. This is toward the low end of a five-year historical range for HP's p-e ratio, and well below an average p-e of about 20.9 times. The valuation for HP is also at discount to a recent p-e level of 16.7 times for companies in the S&P 500 Information Technology Sector based on S&P estimates for 2008 earnings. Our target price of 61 assumes multiple expansion based on our view of solid revenue and earnings growth and successful integration of EDS.

The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).

COMPANY PROFILE

Founded in 1939 and based in Palo Alto, Calif., Hewlett-Packard is an information technology company doing business in over 170 countries worldwide. The company is among the largest IT companies, with fiscal 2007 revenues of $104 billion that we estimate will grow organically and by acquisition to $119 billion for fiscal 2008, and to about $146 billion in fiscal 2009. More than most other IT companies, HP derives its sales from overseas, with two-thirds of fiscal 2007 sales coming from outside the U.S. This international presence reduces single country market risk, in our view. The company had 172,000 employees at the end of fiscal 2007.

The company is a top competitor in several key IT markets. It holds a leading market share of about 18.9% in personal computers, based on worldwide PC unit shipments in the second quarter of 2008, as tallied by market research firm IDC. It competes with rivals Dell (DELL) (16.4% second-quarter 2008 market share), Acer (9.5%), Lenovo (7.9%), Toshiba (4.5%), and Apple (AAPL) (3.5%) in the PC arena. The PC market is a large one, with global sales near $261 billion in 2007 and estimated near $286 billion for 2008 by IDC.

In an overall server market worth about $54.4 billion in 2007, HP is a close second to rival IBM IBM (IBM), with about a 28.3% market share of worldwide server factory revenue for 2007, as tracked by IDC. Market leader IBM had 31.9% share in 2007, and Dell (11.3%) and Sun Microsystems (JAVA) (10.8%) vied for third place. HP gained share vs. IBM in 2007, and we believe the company is well positioned to gain share in the future because it is prominent in the large and fast-growing "volume server" market, whereas IBM has strengths in higher-end markets that might see less rapid growth.

Printers and imaging solutions are another prime area for HP, where it competes against the likes of Canon (CAJ), Xerox (XRX), and Lexmark (LXK). The segment has been a strong profit area for HP, representing about 27% of fiscal 2007 revenue but 41% of earnings from operations.

The revenue by segment for fiscal 2007, that is, for the pre-EDS Hewlett-Packard, looked as follows:

Technology Solutions Group: 36% (Enterprise Storage and Servers 18%, HP Services 16%, HP Software 2%)

Personal Systems Group: 34%

Imaging and Printing Group: 27%

HP Financial Services: 2%

Corporate Investments: 1%

COMPANY OUTLOOK

Following the Aug. 26, 2008, acquisition of EDS for about $13.9 billion in cash, the company more than doubled the size of its services operations. EDS had revenues of $22.1 billion for calendar 2007. In comparison, HP had fiscal 2007 services segment revenue of $16.6 billion. Simplistically, adding the EDS 2007 revenue of $22.1 billion to HP's total fiscal 2007 revenue of $105.7 billion gives a combined company size of $127.8 billion, of which services would be about $38.7 billion or 30%.

Of course, this sort of calculation omits growth in 2008 and cutbacks by HP, which could be sizable. On Sept. 15, the company announced a workforce reduction plan that would affect about 24,600 staff, or about 7.5% of the combined company's staff. About half the cuts are expected to be in the U.S., which we presume to be among the higher-cost positions. Furthermore, the company says it plans to replace about half the eliminated positions over the course of three years as it attempts to right-size operations around the world.

By both company and IDC estimates, the EDS deal lifts HP to the No. 2 spot in total IT services behind IBM. HP estimates IBM as having about 10% market share, EDS/HP with 7%, Accenture (ACN) 4%, and Fujitsu 3%. Overall, we believe the more even balance of services in revenue mix for HP should contribute to revenue stability by the long-term nature of service contracts, as opposed to one-time sales of hardware. Also, there should be opportunities for HP to cross-sell products and services to its larger customer base. We view IBM as having demonstrated success with a balanced hardware, software, and services segment mix, and believe that HP is on the right track in emulating IBM in this regard. We view rival Dell as suddenly the odd man out, being a large computer maker that has not bulked up in services as much as HP or IBM.

We believe a prime benefit of HP's restructuring program following the EDS deal is its plan to cut annual costs by about $1.8 billion. Naturally, nothing is free, and the company plans to record a $1.7 billion charge in the fiscal 2008 fourth quarter, of which $1.4 billion will be goodwill and $0.3 billion will be recorded as a GAAP restructuring charge.

VALUATION

We view HP shares as compellingly valued at a recent p-e of 11.6 times, based on our calendar 2008 EPS estimate of $3.72 (excluding acquisition and restructuring-related charges) and a recent price of 43. This is toward the low end of a five-year historical range for HP's p-e, and well below an average p-e of about 20.9 times. The valuation for HP is also at discount to a recent p-e level of 16.7 times for companies in the S&P 500 Information Technology sector based on S&P estimates for 2008 earnings. By the end of our 12-month investment horizon, we expect to see multiple expansion, assuming growth continues near our forecasts and the EDS acquisition is assimilated effectively.

On a calendar 2008 basis for earnings, HP at a p-e of 11.6 times compares well with computer hardware peers, by our analysis, with IBM at 11.5 times, and Dell at 10.5 times. We view HP as having more potential for upside surprises to earnings than these peers, based on potential efficiency gains from the EDS acquisition.

The company has a small quarterly cash dividend indicated at 32¢ annually, or a 0.7% yield.

HP took on debt in part to keep the EDS acquisition a cash deal and not have to issue shares, and has levered the company's debt position to the high end of its range for the decade. We view the debt load as substantial, but manageable.

We look at the share count situation favorably as the company continues a strategy of repurchases. On Sept. 22, the board authorized the repurchase of up to $8 billion in shares; the company has about 2.5 billion shares outstanding. We believe the buybacks are large enough to support EPS and perhaps smooth short-term fluctuations in share price.

CORPORATE GOVERNANCE

Positive points we see for HP's corporate governance include the board's large majority of independent directors, the annual election of directors, and a general lack of anti-takeover or so-called "poison pill provisions." Other aspects of corporate governance that we view as constructive are a compensation committee made up of independent outside directors, a board approved succession plan for the CEO position, and a lack of "related party" transactions by directors.

However, the board chairman and CEO positions are held by the same person, which is a concentration of power that we believe can create an element of corporate governance risk.

INVESTMENT RISKS

Risks to our investment recommendation and target price include the possibilities of slower global economic growth and demand for information technology goods than we project, market share loss, competitive pricing, and failure to innovate new products in line with the IT industry.

We believe HP has a higher risk and higher reward profile compared with some IT company peers in terms of acquisition integration, in light of the large size the EDS acquisition and the continuation of smaller acquisitions such as the planned acquisition of LeftHand Networks for $360 million in cash, announced on Oct. 1, less than a month after the $13.9 billion EDS deal was completed. While the company has successfully integrated large acquisitions, such as Compaq in 2002, even before present management arrived and established a reputation as effective reorganizers and cost-cutters, investors should be aware there is a risk that the integrations of EDS and other acquisitions may take longer, cost more, and be less effective than planned.


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